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GGP part 5 - The Comprehensive Analysis is finally here

Here is the GGP
analysis, 38 pages long, but chocked full of info, analysis, and
understanding of the CRE market and GGP in partifcular. Review this
report, and compare it to what you recieve from your sell side bank or
brokerage. I am anxious to hear your feedback. Blog members can download it here:

General Growth Properties (GGP)
seems headed for a difficult operating environment in the wake of deteriorating
economic fundamentals in US and the company’s huge financial debt liability. We
believe that while operating cash flows would get impacted by lowering
commercial real estate rentals in the US, increased interest burden off
tightening lending standards by large financial institutions amid concerns over
incremental exposure of the structured securities to the securitized loan
crisis would weigh on the company’s near-to-medium earnings. The problem could
get aggravated with rising losses from probable foreclosure of mortgages on
some of GGP’s prime but high leveraged properties, in our view.

Key Points

·Commercial real estate rentals headed southwards: With US
recession looming large and increasingly being pushed by a slowdown in US
consumer spending, lower-than-expected US retail sales in 4Q2007 and rising
unemployment rate, demand for commercial real estate is expected to slow down,
creating downward pressure on the commercial real estate rentals. US retail sales
for December 2007 declined 0.4% over November 2007 levels, and unemployment
rate rose to 5% in December, the highest level since 4Q2005. The
near-to-medium-term outlook doesn’t present a favorable trend in the commercial
real estate rentals amid weakening macro-economic indicators in the US.

·Refinancing challenges for GGP’s huge debt liability
amid tightening credit market As of September 30, 2007, GGP had an
outstanding debt of approximately $24 billion, of which $2.6 bn and $3.3 bn is
due for payment in 2008 and 2009, respectively. By 2011, more than 70% GGP’s debt
(approximately $17.6 billion) is scheduled to be repaid, which would be
possible only through the refinancing option. Following the US sub-prime
meltdown in mid-2007, the credit market has squeezed significantly. With
tightening of lending standards in the global credit market, it looks extremely
difficult for GGP to refinance its huge debt liabilities. Any further
deterioration in the capital market conditions, impairing GGP’s ability to
re-finance its debt obligations, could significantly jeopardize the company’s
re-development plans. Consequently, GGP could be forced to foreclose mortgages
on some of its prime, but highly leveraged properties. Alternately, to avoid
foreclosure GGP may be forced to sell assets in a period of tight liquidity,
hence lower aggregate sales values for those properties which would have
fetched a significantly higher price just a year earlier.

·Rising interest burden: As the financial
performance of large financial institutions including Merrill Lynch, Citigroup
and JP Morgan is being impacted by huge sub-prime losses and the market is
adjusting their valuation (demonstrated byin the rapid decline in their share
price in last one month), these institutions have become more selective in
lending funds to consumers and the corporate world. This, in our opinion, would
negatively impact GGP’s ability to negotiate with large banks and credit
institutions as lenders get more conservative and impose stringent lending
conditions such as a low level of loan-to-value (LTV) ratio. We expect the
effective interest rate of company’s debt to rise over the present levels as
the company starts refinancing its debts due for repayment in next couple of
years. With cash flow from operations expected to rise at a moderate level and
interest rate soaring to extremely uncomfortable levels, GGP might need a
refinance facility to refinance its interest liability. This could result in a
very tight operating environment for the company especially in the absence of
any near-to-medium-term favorable drivers in the US real estate sector. The
company’s management has not exhibited, in our opinion, the ability to
outperform in a tight operating environment. The requisite margin for error
needed to see this company profitably though the next 8 quarters is just not
there.

Low cap rates for recently acquired property: GGP purchased a
significant part of its portfolio in 2006 and 2007 with a median cap rate of
2.7% and 3.8%, respectively, compared with a median cap rate of 8.2% for the
portfolio purchased in the late 1990s and early 2000s. This suggests that the
company has made expensive purchases in the recent years, which have impacted
its median cap rate at an overall level. With
adverse macro-economic conditions and commercial rentals likely to be
negatively impacted, these properties seem to have not been appropriately
valued in GGP’s financial statements. GGP has over 100 commercial real estate
properties with negative equity (present value of future cash flows less
mortgage).Of these around 70% were acquired in the past couple
of years at the time when credit availability was relatively easy and property
prices were at their peak, supporting and reinforcing our findings that a large number of these properties are
significantly overvalued.

·Stock trading at a 52-week low – Owing to an
expected slowdown in the commercial real estate sector, coupled with a recent
credit crunch crisis, GGP’s stock has witnessed a significant decline over the
past six months. GGP’s stock price declined nearly 50% from its peak of $67.4
on March 23, 2007, to $33.6 as on January 17, 2008, after trading at a 52-week
low price of $31.43 on January 16, 2008. Notably, the stock witnessed a
significant 24.9% decline in past one month from its price of $44.45 as on
December 14, 2007.

·Repercussions of US Subprime &
loose lending market – As a result of the write-down from sub-prime
mortgage related losses stemming from lax underwriting standards, financial
companies in US are in distress. According to a Bloomberg survey of analysts,
financial companies in the S&P 500 index are expected to report a 69% drop
in earnings for 4Q2007, which could drag the earnings for the overall index by
10%. So far 4Q2007 results and the recent macro economic data point to a high
probability of recession in US. In 4Q2007, Citigroup had written-down $18 bn
relating to mortgage default and reported net loss of $9.83 bn, while. J.P.
Morgan Chase recorded $1.3 billion write-down on subprime losses with a 34.3%
decline in net profit.Besides financial
institutions, many retailers have downgraded their guidance for 4Q2007 results.
Sears Holdings expects a 51% y-o-y decline in net income for 4Q2007 citing
concerns over increased competition and the negative impact of unfavorable
economic conditions, amid deteriorating residential market and credit market
concerns. We believe that a decline in corporate and specifically retail sector
profitability, as evident in the recent run-up of events coupled with
decreasing consumer spending could result in the faster onset of recession in the
US, which will translate into more aggressive downside risk to GGP’s stock
price.

·Insider transaction activity
draws our attention – Many
of GGP’s top executives exercised their stock options over 2007 in anticipation
of realizing huge premiums by selling their holdings in the open market at the
then prevailing considerably higher prices. The company insiders have been net
buyers of GGP stock worth $42.8 million, with purchases of $55.3 million at an
average price of $57.95 and sales worth $12.4 million at an average selling
price of $46.69. While the average option conversion price in 2007 was around
$35.2, the average market price of GGP’s share over the period when these
options were exercised was around $63.6, indicating the huge prospective
premium that was attached for the company’s top management in exercising their
options. However, the conditions reversed speedily and GGP’s share price took a
sharp downturn during the later part of 2007, leaving most of the investors
including the insiders in a tizzy. While a few of the insiders have shown
tendency to make the most of the situation and disposed off their holdings in
the recent months, the others are still holding to their stock as of now.
Another interesting fact to note is that during 2006 and 2007, GGP’s CFO
received an option award of 342,896 shares and 1,37,347 with conversion prices
of $50.47 and $65.81, respectively, while GGP COO received an option award of
3,34,317 shares and 1,33,613 shares with conversion prices of $50.47 and
$65.81. Both the CFO and COO had an unusual stock option award in 2006,
independent of the rest of the management team. Also, while GGP COO sold stock
worth $1.4 mn in December 2007, the CFO purchased stock worth $52 mn in 2007
including huge purchases from the open market.